Economics Model Essay 13

(a) Explain the relative importance of the factors which affect the price of petrol in Singapore. [10]
(b) Discuss the effects of an increase in the tax on petrol in Singapore on the related markets. [15]

Introduction

(a) The relative importance of the factors which affect the price of petrol in Singapore can be discussed with reference to the concepts of demand, supply, income elasticity of demand and price elasticity of demand.

Body

The price of petrol is determined by the market forces of demand and supply. The demand for a good is the quantity of the good that consumers are willing and able to buy at each price over a period of time, ceteris paribus. The supply of a good is the quantity of the good that firms are willing and able to sell at each price over a period of time, ceteris paribus. An increase in the demand for petrol will lead to a rise in the price and vice versa. An increase in the supply of petrol will lead to a fall in the price and vice versa.

In the above diagram, an increase in the demand (D) from D0 to D1 leads to a rise in the price (P) from P0 to P1. Given the demand (D0) and the supply (S0), the price and the quantity are P0 and Q0. When the demand increases from D0 to D1, although the quantity demanded rises at the same price (P0), the quantity supplied remains at Q0 and this results in a shortage. When firms do not produce enough to sell, they can raise the price without losing sales. Therefore, they will do so to increase their profits. As the price rises, the quantity demanded falls and the quantity supplied rises and this process continues until the price rises to P1 where the quantity demanded and the quantity supplied are equal at Q1.

In the above diagram, an increase in the supply (S) from S0 to S1 leads to a fall in the price (P) from P0 to P1.

The demand factors which affect the price of petrol are less important in Singapore. The income elasticity of demand for a good is a measure of the degree of responsiveness of the demand to a change in income, ceteris paribus. As the income elasticity of demand for private cars is positive, which means that they are a normal good, an increase in income will lead to a rise in the demand. Generally, when the demand for private cars rises, the demand for petrol will rise. However, this is not the case in Singapore. An increase in the demand for private cars will lead to an increase in the demand for petrol as it will lead to an increase in the quantity of cars. However, due to the quota on the number of cars imposed by the Singapore government through the Certificate of Entitlement (COE) system, an increase in the demand for private cars will not lead to an increase in the quantity and hence will not lead to an increase in the demand for petrol. With the COE system in Singapore, the quantity of cars and hence the demand for petrol will increase only when there is an increase in the supply of cars through an increase in the supply of COEs. However, in an effort to move towards a car-lite society, the Singapore government has cut the growth rate of private cars to zero per cent. This is due to the competing needs for the small land area of Singapore which is only about 720 square kilometres, and the fact that already 12 per cent of it has been used to build roads, resulting in limited scope for further expansion of the road network.

The supply factors which affect the price of petrol are more important in Singapore. Crude oil is a major factor input which is used in the production of petrol as petrol is produced with crude oil through the process of fractional distillation. Therefore, the cost of crude oil accounts for a large proportion of the cost of production of petrol. It follows that a change in the price of crude oil is likely to lead to a large change in the cost of production of petrol and hence a large change in the supply. Furthermore, as crude oil is a commodity which is traded on the futures market, the price is subject to speculation. Therefore, the price of crude oil is volatile. The Singapore government imposes a high tax on petrol. Therefore, the tax on petrol accounts for a large proportion of the cost of production. It follows that when the Singapore government increases the tax on petrol, the cost of production is likely to increase by a large extent and hence the supply is likely to fall by a large extent. The price elasticity of demand for a good is a measure of the degree of responsiveness of the quantity demanded to a change in the price, ceteris paribus. The demand for petrol is likely to be price inelastic due to the high degree of necessity and lack of close substitutes. Therefore, a change in the supply is likely to lead to a large change in the price.

In the above diagram, due to the inelastic demand which gives rise to the relatively steep demand curve (D0), a decrease in the supply (S) from S0 to S1 leads to a large rise in the price (P) from P0 to P1, and an increase in the supply from S0 to S2 leads to a large fall in the price from P0 to P2.

Conclusion

In conclusion, the supply factors which affect the price of petrol in Singapore are more important than the demand factors.

Introduction

(b) The effects of an increase in the tax on petrol in Singapore on the related markets can be discussed with reference to the concepts of demand, supply, price elasticity of demand, cross elasticity of demand and price elasticity of supply.

Body

An increase in the tax on petrol in Singapore will affect the market for petrol. An increase in the tax on petrol in Singapore will lead to a rise in the cost of production. When this happens, the supply will fall which will lead to a fall in the quantity and a rise in the price. When the supply of petrol falls, whether the price or the quantity will change by a larger proportion will depend on the price elasticity of demand. As the demand for petrol is likely to be price inelastic due to the high degree of necessity and lack of close substitutes, the price is likely to rise by a larger proportion than the fall in the quantity.

In the above diagram, due to the inelastic demand which gives rise to the relatively steep demand curve (D0), a decrease in the supply (S) from S0 to S1 leads to a large rise in the price (P) from P0 to P1 and a small fall in the quantity (Q) from Q0 to Q1.

An increase in the tax on petrol in Singapore will affect the market for private cars. The cross elasticity of demand for a good with respect to another good is a measure of the degree of responsiveness of the demand for the first good to a change in the price of the second good, ceteris paribus. As the cross elasticity of demand for private cars and petrol is negative, which means that they are complements, the rise in the price of petrol in Singapore due to the decrease in the supply will lead to a decrease in the demand for private cars. When this happens, the price will fall and the effect on the quantity will depend on the extent of the decrease in the demand. If the decrease in the demand is small, the quantity is likely to remain constant.

In the above diagram, a small decrease in the demand (D) from D0 to D1 leads to a fall in the price (P) from P0 to P1. The quantity (Q) remains constant at Q0. However, if the decrease in the demand is large, the quantity is likely to fall.

In the above diagram, a large decrease in the demand (D) from D0 to D1 leads to a fall in the price (P) from P0 to P1 and a fall in the quantity (Q) from Q0 to Q1. The cost of a car is high in Singapore due to the high cost of a COE and the high additional registration fee. Therefore, the cost of petrol is low relative to the cost of a car. It follows that the cross elasticity of demand for private cars with respect to petrol due to a rise in the price of petrol is likely to be low. Therefore, the rise in the price of petrol due to the decrease in the supply is likely to lead to a small decrease in the demand for private cars.

An increase in the tax on petrol in Singapore will affect the market for private-hire car services. Private cars and private-hire car services are substitutes and hence the decrease in the demand for private cars in Singapore will lead to an increase in the demand for private-hire car services. When this happens, the price and the quantity will rise. When the demand for private-hire car services rises, whether the price or the quantity will rise by a larger proportion will depend on the price elasticity of supply. The price elasticity of supply of a good is a measure of the degree of responsiveness of the quantity supplied to a change in the price, ceteris paribus. The supply of private-hire car services is likely to be price elastic as anyone with a driving license can become a provider of private-hire car services. Owning a car is not a requisite as one can easily rent a car from the private-hire car service company or from any of the large number of car rental companies. Therefore, the quantity is likely to rise by a larger proportion than the price. When the price of petrol rises, the cost of production of private-hire car services will rise which will decrease the supply. When this happens, the price will rise and the quantity will fall. The demand for private-hire car services is likely to be price elastic due to the large number of substitutes which include taxi services, bus services, train services and private cars. Therefore, the quantity is likely to fall by a larger proportion than the rise in the price. The increase in the demand and the decrease in the supply will both lead to a rise in the price. Although the increase in the demand will lead to a rise in the quantity, the decrease in the supply will lead to a fall in the quantity. Due to the elastic supply, the increase in the demand is likely to lead to a large increase in the quantity, and due to the elastic demand, the decrease in the supply is likely to lead to a large decrease in the quantity. Therefore, the effect on the quantity will depend to a large extent on the relative changes in the demand and the supply. As the decrease in the demand for private cars is likely to be small, the increase in the demand for private-hire car services is likely to be small. The increase in the demand for private-hire car services is also likely to be small due to the large number of other substitutes for private cars which include taxi services, bus services, and train services. Furthermore, as an increase in the tax on petrol is likely to lead to a large rise in the price, it is likely to lead to a large rise in the cost of production of private-hire car services. Coupled with the fact that the cost of petrol accounts for a large proportion of the cost of production of private-hire car services, this is likely to lead to a large decrease in the supply of private-hire car services. Therefore, the decrease in the supply is likely to be greater than the increase in the demand and hence the quantity is likely to fall.

In the above diagram, a larger decrease in the supply (S) from S0 to S1 and a smaller increase in the demand (D) from D0 to D1 lead to a rise in the price (P) from P0 to P1 and a fall in the quantity (Q) from Q0 to Q1.

Conclusion

In conclusion, if the tax on petrol rises in Singapore, the price of petrol will rise and the quantity will fall, the price of private cars will fall and the quantity is likely to remain constant, the price of private-hire car services will rise and the quantity is likely to fall.

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